As we approach the dreaded date of April 15, no doubt many income investors are noticing just how high their tax payments mount up, as both Federal and state taxes take a substantial bite.

Meanwhile, eight years of low interest rates have shrunk the gross dividend and interest payments investors received, as inflation – even at the current core rate of 2% – eats away at the principal.

Alone, each factor is only moderately damaging. But the combination of high taxes, modest inflation, and funny money is a serious threat to investors’ returns.

The System Seems Rigged

Exacerbating this threat is investors’ tendency to take on more risk in an attempt to pad their retirement accounts. Unfortunately, the tax system isn’t fully compensating them for taking more risks.

Capital losses tend to come in lumps, and large capital losses that aren’t matched by gains aren’t tax-deductible above $3,000. Income investors aren’t investing for capital gains, so they may as well not have gains on tech shares and the like, with which they can offset losses.

Following a typical investment strategy, an investor would buy junk bonds with a yield of 7% and master limited partnership (MLP) shares with a yield of 8%, both of which carry a substantial risk of capital losses (as energy MLP investors found out in 2015).

Let’s say, for example, that an MLP investor suffers a 20% loss of his principal after five years of his holding. On a pre-tax basis, he made 40% in income and then lost 20% in a capital loss. This results in a net return of 20% over five years, or roughly 4% per annum.

That’s better than he would’ve done investing in 10-year Treasury bonds, with their average yield of around 2%.

Now let’s look at the post-tax picture.

Suppose he invests $200,000 in MLPs. Over five years, he receives a gross income of $80,000 on his MLP holdings.

That sounds like a decent return, until you realize that if he pays 35% in Federal tax and 6% in state tax on this income (both below the highest possible rates, with MLP income being fully taxable without the dividend tax reduction), he’ll only net $47,200.

Then we have to consider the effects of inflation and the 20% capital loss.

Inflation will reduce the value of his $200,000 by 2% per annum, or $4,000 per year. That’s $20,000 in total, reducing his net after-inflation return to $27,200, or 13.6% on his principal, which is 2.72% per annum.

The 20% capital loss will cost him $40,000, of which only $3,000 will be tax deductible at the 20% Federal capital gains tax rate (and assume again the 6% state tax) if he has no offsetting capital gains. This makes his net loss $39,220.

So overall, he lost $12,020 on his investment after tax and inflation.

Beating the System

Once you take inflation and taxes into account, you have few avenues by which you can preserve capital and earn a little income for retirement.

Treasury bonds themselves only yield just about the inflation rate pre-tax, leaving investors with a loss post-tax.

High-yield alternatives have the risk of capital losses that can’t easily be deducted from tax. As we saw above, that also leaves investors with a loss.

Dividend Aristocrats, stocks that have increased their dividends for 25 or 30 years, are considerably better. If you pick the right one, it’s a true buy and hold investment, so capital gains taxes don’t apply.

Their dividends go up each year. And the prestige of being labeled a Dividend Aristocrat means management won’t likely break the stock’s winning streak.

When investing in Dividend Aristocrats, there are a few things to watch out for: leverage and stock buybacks.

Stock buybacks benefit management in the short term, allowing management to issue itself large stock options without diluting other shareholders. Many companies that follow a conservative policy with respect to dividends, paying out only 30% to 40% of earnings, then waste the rest of their earnings in stock buybacks.

This drains their cash and builds unnecessary leverage, which can cause a cash crunch in the next downturn, preventing the dividend from being paid.

Needless to say, a Dividend Aristocrat that stops paying its dividend is an utterly useless investment. It will kill your portfolio on both income and capital value.

One buy and hold Dividend Aristocrat that I like is Emerson Electric Co. (EMR). Emerson, a $34 billion maker of electrical and electronic equipment, has increased its dividend every year since 1957.

It also has the distinction of only being on its third CEO since 1954, which lends long-term continuity to the company’s strategies.

Emerson offers a yield of 3.8%, based on its current quarterly dividend of $0.475, and is trading on 14.1 times trailing earnings, or 16 times 4-traders’ estimate of 2017 earnings. (2015 was an exceptionally good earnings year.)

Emerson and similar stocks allow income investors to optimize their portfolios. The company makes tangible objects, so its output should rise with inflation, while its dividend increases protect your income.

You should never have to sell it (Fingers crossed!), so there wouldn’t be a capital gains tax. And being an operating company, its dividend is taxed at only 20%, and offers an after-tax yield that’s still above the inflation rate.

The IRS and the Fed have made your job as an income investor very difficult, but stocks like these provide some solutions.

Good investing,

Martin Hutchinson

For 27 years, Martin Hutchinson was an international merchant banker in London, New York, and Zagreb. He ran derivatives platforms for two European banks before serving as director of a Spanish venture capital company, advisor to the Korean company Sunkyong, and chairman of a U.S. modular building company. Learn More >>

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